Chancellor George Osborne said the decision was "a stark reminder of the debt problems facing our country".

"Far from weakening our resolve to deliver our economic recovery plan, this decision redoubles it," he added. "We will go on delivering the plan that has cut the deficit by a quarter."

But the BBC's political editor Nick Robinson said Mr Osborne now risks being dubbed the "downgrade chancellor".

"Worse could follow if the Budget shows borrowing rising... but for most people, what will matter is not credit ratings or statistics but higher fuel, food and other prices and if interest rates go up," he added.

The UK has had a top AAA credit rating since 1978 from both Moody's and S&P.

Shadow chancellor Ed Balls said the decision was a "humiliating blow to a prime minister and chancellor who said keeping our AAA rating was the test of their economic and political credibility".

'Increasing clarity'

Analysis

By Hugh PymChief economics correspondent, BBC News

It was a question of not if, but when.

Financial markets knew a downgrade of the UK's sovereign rating was just a matter of time.

Even so, the announcement by Moody's was a big jolt to the ongoing economic debate.

There is no shame in losing the AAA rating at a time when most leading economies are struggling with the burden of rising debt and lack of growth.

The UK is following the experience of the US and France in 2011.

Their borrowing costs actually fell after the downgrades.

But the symbolism of Britain losing the gold-plated rating for the first time since the 1970s cant be ignored.

George Osborne will have to work hard to explain why, having set great store by retaining the AAA when he arrived at the Treasury, he has now seen it stripped away.

And it seems likely Moody's rival agencies will deliver their own verdicts soon.

In announcing the ratings cut, Moody's cited the "challenges that subdued medium-term growth prospects pose to the government's fiscal consolidation programme, which will now extend well into the next parliament".

It added that the UK's huge debts were unlikely to reverse until 2016.

"The main driver underpinning Moody's decision to downgrade the UK's government bond rating to AA1 is the increasing clarity that, despite considerable structural economic strengths, the UK's economic growth will remain sluggish over the next few years due to the anticipated slow growth of the global economy and the drag on the UK economy," Moody's said.

But it added that the outlook for the UK is "stable", meaning it sees no further downgrades in the near future, and added "the UK's creditworthiness remains extremely high".

BBC business correspondent Jonty Bloom says for the chancellor, who made maintaining Britain's top rating one of the benchmarks of economic success when he came into office, it will be a blow.

It will massively increase the pressure on Mr Osborne, from both those who want him to raise taxes and cut spending further and from those who want him to alter course in next month's Budget and spend more to try to boost growth, says our correspondent.

The UK's net sovereign debt was the equivalent of 68% of the country's annual economic output, or GDP, at the end of last year.

"The very fact that we didn't see this downgrade happen in the past few years is a testament to the UK's credibility," Lena Komileva, an economist at G+ Economics, told the BBC.

"There are no magic fixes for this kind of problem. It's not a question of what the government is willing to do, it is what it can do."

And the BBC's Hugh Pym said that while it was unlikely to have a huge market impact, the downgrade was very much a moment of political significance because the UK had not lost its AAA rating since the 1970s.

CREDIT-RATING AGENCIES

Private-sector firms that assign credit ratings for issuers of debt

A credit rating takes into account the debt issuer's ability to pay back its loan

That in turn affects the interest rate applied to the security (eg a bond) being issued

A credit downgrade can make it more expensive for a government to borrow money

The argument will be over how much credibility Mr Osborne has lost, he said.

Peter Kellner, president of pollsters YouGov, said the news could be a "blame changer" for the UK's economic situation, with people potentially switching blame from Labour to the Conservatives.

"I think the problem for the Tories is if it... comes out in the budget that the growth forecasts and deficit forecasts have gone awry, if living standards don't rise, if it's part of a trickle effect over the next few months that leads people to say the government has got it badly wrong - that is how it could become damaging."

'Gamble failed'

All three major credit agencies last year put the UK on "negative outlook", meaning they could downgrade its rating if performance deteriorates.

In his Autumn Statement in December, Mr Osborne acknowledged public finances were taking longer to rectify than planned, and admitted he would be forced to extend austerity measures by at least another year.

Germany and Canada are the only major economies to currently have a top AAA rating - as much of the world has been shaken by the financial crisis of 2008 and its subsequent debt crises.

A downgrade of a credit rating does not necessarily substantially damage the ability to borrow.

The US - the world's biggest economy - was downgraded from its AAA rating last year, a move that has not materially changed its borrowing costs.

Moody's removed France's AAA rating in November.

The UK has experienced a double-dip recession since 2008. It grew in the third quarter of last year - boosted by the impact of the Olympics, but shrunk again by 0.3% in the last three months of 2012.

Earlier this month, the Organisation for Economic Co-operation and Development said the Bank of England should be ready to inject more money into the economy to boost growth.

The Bank has so far pumped £375bn into the financial system, creating money to buy-back government bonds.

The credibility of ratings agencies have also come under attack. S&P is being sued by the US government over ratings it gave to some mortgage-backed assets in the run-up to the global financial crisis in 2007, which subsequently fell dramatically in value.

Moody's announcement sent the pound falling further in value, but financial analysts said the impact was likely to be limited because the markets had been expecting a downgrade for some time.